What is residual income in accounting?

3. Example of residual income calculation – company level

Let’s assume Travellover Company (a fictitious firm) has $1,000,000 of assets financed 40% by debt (i.e., $400,000) and 60% by equity (i.e., $600,000). The company has earnings before interest and taxes (EBIT) of $100,000. The cost of debt (before taxes) is 6%, and the cost of equity capital is 10%. The tax rate is 35%.

On one side, to determine the residual income, the company can deduct the equity charge from the net income. In this case, the net income and the equity charge can be determined as follows:

1

EBIT

$100,000

2

Less: Interest expense ($400,000 x 6%)

(24,000)

3

Pretax income

76,000

4

Less: Income taxes ($76,000 x 35%)

(26,600)

5

Net income

49,400

6

Less: Equity charge ($600,000 x 10%)

(60,000)

7

Residual income

(10,600)

We can see from this example that even though the company may seem to be profitable (i.e., it has a net income of $49,400), the firm does not earn enough to cover the cost of equity as shown by the negative residual income. In other words, in economic sense the company is not profitable.

On the other side, the company can use net operating profit after tax (NEPAT) to calculate residual income. NOPAT can be determined as follows:

NOPAT = EBIT – Taxes = $100,000 – (100,000 x 35%) = $65,000

Furthermore, the capital charge equals $75,600:

  • Debt charge: 0.06 x (1 – 0.35) x $400,000 = $15,600
  • Equity charge: 0.10 x $600,000 = 60,000

Finally, residual income can be figured out as follows:

1

NOPAT

65,000

2

Less: Capital charge

(76,600)

3

Residual income

(10,600)

If the company calculated the residual income as the different between the NOPAT and the capital charge, the residual income would equal ($10,600). As we can see, in both cases the same residual income value is obtained.

The company’s effective capital charge is 7.56% ($75,600 ÷ $1,000,000), while the NOPAT return on total assets is only 6.5% ($65,000 ÷ 1,000,000). Hence, from an economic prospective the company is not profitable.

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